Today I’d like to offer a simple explanation for how life insurance “works.” This discussion will also lay a foundation for discussing the difference between term and permanent life insurance. The first post in this series, on the reasons someone might need life insurance, is worth reading if you’re not sure whether you need life insurance.

Suppose that you’re a 20-year old male and you’ve decided that you need some life insurance. For the purpose of this illustration, let’s assume you’ve determined that you need $1,000,000 in coverage for an indefinite period of time. Let’s also assume that you dislike insurance companies and you want to find an alternative to traditional life insurance – you want to be your own insurance company. You persuade 999 of your buddies, who (conveniently) also happen to be 20-year old males in need of $1,000,000 in life insurance coverage. You are charged with figuring out how to make the whole thing work at a price you can all afford.

You realize that in order to make this work, you need the advice of an actuary – someone who is an expert in the statistical aspects of insurance. As it happens, you have a family friend, a college statistics professor, who also happens to be an actuary. He agrees to calculate, each year, how much each of you needs to contribute to make the scheme work. Let’s also assume that the group’s future death rate approximates that of the general population of 20-year old men, so that the Commissioners 2001 Standard Ordinary Mortality Table accurately describes the group’s mortality rate as time goes on.

Your actuary informs you that in the first year, there is a 0.1% chance of death for a 20-year old male, meaning that the group as a whole should suffer one death. Accordingly, each man pays $1,000.00 into the fund, which collects a low rate of interest until it is paid out to any beneficiaries. You hire a law firm to prepare a binding legal agreement that you all sign. The agreement provides that while alive, you each agree to pool sufficient funds annually, according to the group’s statistical risk of dying, in order to collectively fund life insurance coverage for everyone. The first year’s interest pays the lawyers, with something left over for the professor as a token of thanks for his help. The small amount that remains each year is kept to pay administrative expenses.

After year 1, one man has died, and his benefit has been paid. This leaves 999 of you with a probability of death that is still essentially 0.1%. Each man now pays $1,001.00 to provide $1MM coverage for the chap expected to die in year 2. This goes on until you are all about to turn 30. There are 990 of you still alive, each now paying a premium of $1,010.00. Several of your brighter friends begin to realize that as the group continues to shrink, the cost of insurance will fall on fewer and fewer wallets. They wonder what their future premiums will be, and ask you how much their premiums can be expected to increase. You ask the professor, who prepares the following graph for them in reply:

The guys are stunned when they realize that by the time they reach their late sixties their premiums will be twenty times what they pay now. One fellow (the guy who was captain of your high school math team) calculates that by the time he’s 80, he will have paid out almost $800,000 in total premiums – a good chunk of the death benefit he’s paying for. This news causes even more dismay as the men realize that they signed a binding contract ten years ago. You notice a fair amount of grumbling among the group’s members, including some murmurings about who might be expected to expire suddenly in the near future. Concerned, you decide to ask the professor if there’s some other way to keep everyone’s coverage without having the premiums balloon as you approach middle age.

He explains that there is a way: you could all pay a larger premium, but it would remain constant year after year. Instead of paying in only enough each year to cover one year’s deaths, you would pay in more than is needed for the coming year. The excess contributions would need to be conservatively invested and would provide a reserve fund to pay for future deaths as the death rate increases and the group’s size diminishes. Off the top of his head, he estimates that the new level premium would need to be five or six thousand dollars a year.

You’re a bit panic-stricken by this news; you’re not too confident that your friends, many of whom have young children, will be able to afford such a large premium increase.

You begin doing research to find out which foreign countries don’t have extradition treaties with the U.S. While at the library, you run into a member of the group who is now a very successful lawyer. He proposes a solution, and you’re all ears. He notes that there is a small amount of reserve money left over in the group’s fund, and offers to figure out a way to break the contract in return for a fee not to exceed the fund’s balance. Since you weren’t excited about the prospect of fleeing the country anyway, you accept his offer. Within a couple of days he has found a loophole in the contract. You call a meeting of the group and explain that the arrangement will be terminated when you reach 35. At that point the premium payments will still be relatively low as you’ll only expect to have one death benefit to pay out each year. Everyone is pleased by this news, and you resign yourself to having to shop for insurance in a few years.

What you and your friends have done is invent your own version of term life insurance. In this case, you used what is called one-year term insurance, in which the premium is adjusted each year to reflect the new mortality rate for the group. What you discovered (the hard way) is that one-year term is quite inexpensive for younger people younger, but as those insured get older, the effect of increased mortality causes the cost of insurance to increase at an accelerating pace.

The alternative approach proposed by your actuary friend was a type of “level premium” insurance. That option was analogous to whole life insurance, in which you pay a fixed premium that exceeds the amount needed to pay for death benefits, administrative costs, and profits.

Although the illustration gives you an idea of how insurance is funded by an insurance company, there are many important differences between this example and a conventional life insurance policy. For one thing, modern insurance companies are usually for-profit organizations. In the early history of insurance it was common for insurers to use a cooperative (mutual insurance) model in which policyholders also had some ownership rights in the company. Although there are still a number of mutual insurance companies in the US, most insurers operate as stockholder-owned corporations. Provisions for profit are figured into the premium along with the costs of death benefit payouts and administration.

Another important difference is that a life insurance policyholder is always free to stop paying premiums and terminate the policy. Insurance contracts are thus unilateral: only one of the parties (the insurer) makes a binding promise; the insured may or may not pay the premiums without violating the contract. The insurance provider is bound to fulfill the terms of its obligation to pay out a death benefit as long as you keep the policy in force by paying the premiums, but you have the option of ending the coverage.

The fact that an insured person can terminate the contract has another interesting consequence. Imagine that in our earlier example the men had not been bound to keep paying into their insurance fund, and remember that each year there was a little bit of income left over that was kept as a reserve. Suppose that one year half of the men had suddenly decided to pull out of the arrangement. Suddenly the reserve amount would have been divided among half as many men, resulting in more dollars per man. So depending on how the reserve is allocated, policyholders who let their policies lapse forfeit some funds that they otherwise would be entitled to, and someone else – either the insurer, the remaining insured parties, or both – benefits from the forfeited funds.

Insurers typically provide coverage for a wide range of insured persons, not only in terms of age, but also in terms of health. Insurance actuaries must make allowances for the fact that a person who smokes is more likely to die than a person who does not. Insurers consider a wide range of factors in deciding how to price an insurance policy. When individuals apply for insurance, it’s quite typical for the insurer to ask to see the applicant’s medical records and to require a medical examination before issuing coverage. The insurer wants to know what it’s getting into in terms of risk; it will set the price of the policy according to the risk that the death benefit will need to be paid out. There are certain protections for the insurer; for example, if the applicant can be shown to have committed fraud in the application process, the insurer is freed from the requirement to pay the death benefit.

I’ll discuss the different forms of insurance in more detail in a later post, but for now, I hope you can see that there are basically two ways to fund a life insurance policy: through payments that only cover a year’s death proceeds, or through payments that in some way provide a “running start” toward accumulating funds for future death benefits. Excess funding can occur in a number of ways – a single lump sum could be paid out at the beginning, or a lengthy series of smaller payments could be made, or something in between. Hopefully you can also see that the duration of the coverage will affect the size of the premium. A policy that only provides coverage for five years will be cheaper than one that provides coverage for 30 years or more.

Next we’ll tackle the question of how to determine the amount of life insurance coverage you need.